Trader’s Narrative

Here’s this week’s short but sweet sentiment overview:

Sentiment Surveys
The retail investor’s sentiment as measured by the weekly AAII survey saw the bulls at 38% (a drop of 7% points) and the bears at 43%, with a 10% point increase. While this is a small increase in bearishness, when you consider that we are still very close to an important support level, it is disappointing to see so many optimists.

The Investor’s Intelligence sentiment, which measures newsletter editor’s sentiment, was hardly changed with 31.9% bulls and 46.1% bears. While contrarians may not like the fact that there has been a mad dash away from extreme pessimism in these sentiment gauges, there is another more lenient interpretation. According to Gray and Burke, the duo that reads and categorizes each newsletter editor as bullish, bearish or neutral for ChartCraft, the fact that we saw such a move may be normal. Previous market lows have seen such a shift as bulls increase over time as the market recovers.

ISE Sentiment
On Wednesday, when we stood at the precipice, looking down and the abyss looked back at us, the ISE sentiment data shows that we finally got some semblance of fear from retail options traders. On November 12th, 2008 the ISEE sentiment index (all data) reached 67 - which is on point above where the ISE ratio was on September 19th, 2008 when the S&P 500 Index was at 1255.

This historically useful contrarian indicator may be returning to its usual pattern. But frankly, I’m growing impatient as along with the rest of the options market, it has been acting crazy during this latest market decline. Since I prefer using the equity only data for the CBOE options data, I looked at the same for the ISE options data and came away with an interesting observation. For some reason, during the past six months, the data is within a much narrower range than before:

I’m not sure what to make of this but there it is. I’m sure brighter minds out there will see the significance and perhaps decide to share their insight.

But just so there is no confusion, the low I mentioned before (67) on Wednesday was for all data (equity, ETF and indices options), not just the equity data.

I took a few days off (hope you didn’t miss me too much). Let’s catch up by looking at the important sentiment developments:

ISE Sentiment
I mentioned the ISEE during last week’s sentiment overview when it increased slightly as the market fell, showing that retail option traders were seemingly not worried. Even more bizarre, during the past shortened trading week as the market staged a strong recovery, the ISEE value actually fell.

Part of the explanation for this aberrant behavior may be that I’m looking at the “All Securities” data for the ISEE, rather than the “Equities Only”. The latter measure showed no similar increase for the week of May 23rd.

CBOE Put Call Ratio
Again, in contrast to the ISEE’s behavior, the CBOE equities only put call ratio showed this past week that traders became more bullish as the market rose. Although not the ideal, this is the normal pattern.

The put call ratio fell to 0.59 - approaching levels of bullishness which have previously caused stock market rallies much difficulty.

Hulbert Newsletter Sentiment
According to Mark Hulbert, the Hulbert Stock Newsletter Sentiment Index (HSNSI) has almost doubled from +16.2% to +31.2%. And it did so from mid May to the end of May 2008. Although this is an significant increase, I don’t think it presents us with a situation commensurate with market top.

To give you an idea, during mid to late April 2006 the HSNSI reached +73.2% - when the S&P 500 index soon after fell from 1325 to 1225. And during the bear market bottom in October 2002, it fell below -60%. So all I can say from the current reading is that more newsletter editors are jumping into the bullish camp but still not enough to cause serious problems.

AAII
According to the American Association of Individual Investors’ sentiment survey, there are now 31% bulls, down 15% points from last week’s 46% bulls.

This is a welcome reprieve, especially as it is accompanied by a lower market. Had this key sentiment survey remained unchanged or actually increased in bullishness, the sentiment tone would be definitely different.

Investor’s Intelligence
Similar to the AAII survey, the II sentiment measure fell from 47% bullish to 37.9%. I was worried about this since last week’s number was almost 50%. The keepers of this measure, the editors of ChartCraft, Burke and Gray agree with my general take on the market’s sentiment:

“While the sentiment is moving away from a bullish reading it is not yet close to calling for a market top”

I continue to see a lot of long term positives for the market and continue to believe the March bottom to be a major one. What I suspect we are seeing is a (hopefully) shallow pull back or pause before the next leg up.

Magazine Cover Indicator
Uh oh. Anyone long crude oil or any traditional energy related equities should be worried.

The Economist isn’t the most widely read publication but their cover stories still do carry weight - in a contrary sense most of the time. The price of crude has already tapered off and I suspect this will be either a significant top or at minimum a longish pause.

There are, of course, other signs that the whole energy rally has run its course. There are several technical signs, including the increasingly sharp slope of the trendlines as well as ominous candlestick formations.

My continued bullishness may be seen by some as stubborn, but after looking at the sentiment out there, what other position can you take?

Option Traders Freak Out
The ISEE index recovered from a low of 60 - a low enough level to show severe panic in retail option traders. Although we don’t have long term data for this ratio, the data that we do have indicates that this is low enough to stoke a rally or at least halt a decline.

The more traditional CBOE (equity only) put call ratio once again came in near 1.0 today - this is the third time this week that it has been above or just at parity. In the past 4 years, we’ve only seen parity broken a handful of times. But to see a grouping of such high put call ratios is highly unusual.

I think it is safe to say that option traders, and especially the least experience and least capitalized of them (retail) are in full freak out mode:

Sentiment Surveys
The only traditional sentiment measure that is not showing excessive bearishness is Investor’s Intelligence with 45.6% bulls and 26.7% bears. A few people have asked me about the disparity between it and other sentiment indicators. Honestly I don’t know what is really going on but as I’ve said before, you have to understand that it is very different from other measures.

For one, newsletter writers are a generally more optimistic bunch (since bullishness sells better than its counterpart). Second, II is tabulated through the subjective thinking of one person, Michael Burke. He categorizes newsletters as either bulls, bears or neutral from not necessarily their portfolios but also what the writer is saying. Since the newsletters can’t themselves, in effect, “vote”, this measure is open to the personal bias of one person.

So maybe that explains the discrepancy or maybe it doesn’t. In the end, it is one measure among many. I’d rather take the general judgement of the group, than single out any one of them.

LowRisk’s recent 30 day outlook is decidedly gloomy with 56% bearish and 32% bullish. Market Vane’s bullish percent dropped to 48% and although that sounds too high already to be bullish, you have to consider that for the past 4 years, it has oscillated between 75% and 55%. Likewise, Consensus‘ bullishness is at 47%.

AAII is showing panic-level bearishness again with 54% bears and only 24% bulls. Check out last week’s chart to see the correlation between such high bearish AAII sentiment and stock market performance.

According to Jason Goepfert, waiting two weeks after a bearish percentage above 50% gives us a better chance of finding a winning trade: 24 from 29 instances with an average return of +3.1% (over two months). He also says that the “average drawdown (i.e. maximum loss) of -3.2% was dwarfed by the average maximum gain during the trades of +5.7%.”

Rydex Ursa/Nova Ratio
Before leveraged ETFs, the only way retail traders got long or short aggressively was through the Rydex Nova/Ursa funds. Although they have become somewhat of an anachronism, their ratio is still useful to show the retail investor’s mood.

Not surprisingly, we are seeing a dash into the bearish leveraged fund (Ursa) as the “dumb money” goes into panic over the recent market losses.

Here’s a quick recap of sentiment indicators for the past week as I saw them:

AAII Sentiment Survey
Retail investors are feeling rather cheeky with 48% bullish and only 36% bearish. Just a few weeks ago less than a third were bullish, and now almost half are. I’m surprised by this quick move.

According to contrarian analysis, this isn’t a good omen for the market going forward. According to data from 1988 to 2007, the market performs best when AAII sentiment is bearish. The more gloomy, the better.

[EDIT: About 3 weeks later (on Jan 2nd), AAII bearishness rocketed to 55%]

The S&P 500 has gone up an average of 18.1% 26 weeks after a bearish sentiment reading above 50%. Right now, we aren’t even close to this sort of pessimism. So be careful out there.

Investor’s Intelligence
Stock newsletter editors are by far too optimistic now. According to Burke only 25.6% are bearish and 53.3% bullish. Too much euphoria right now in newsletter land. I’d be careful since this matches the other sentiment readings.

LowRisk
According to LowRisk, there are 36% bulls and 30% bears. The last time there were more bulls than bears was back in November 20th.

The four week moving average of the bull ratio is above 50% - a level which usually corresponds with thin air altitudes for the market.

Well, that was something. Wasn’t it?

Simply breathtaking.

I love it when things align like that. I had to take care of some things yesterday or you would have found me gloating about this much earlier

An old saying around Wall Street is that the market moves to exert maximum pain to the maximum number of participants. If this isn’t what just happened, I don’t know what is. Who in their right mind could have foreseen what happened this week? the breakout? the sheer intensity and unrelenting buying pressure?

Unfortunately for them, those that bear the brunt of the damage tend to be the outsiders, the unwashed masses, otherwise known as retail investors and traders. For the most part, insiders make out just fine.

Speaking of insiders, the latest Commitment of Traders report, hot off the presses, shows a continuation of the same lopsided buying from the commercials. Brace yourself, because since the last report, commercials have increased their aggregate net long position by 36%.

Eventhough I was bullish as I outlined this past week, I was still taken aback by the force of the bulls. They simply demolished the bears. I don’t care what thesis a bear trots out: inflation, the dollar, China, etc… it is all meaningless in the face of such a clear and powerful breakout.

What’s more fascinating is that according to the Hulbert sentiment measures, newsletter publishers are not at all excited about the market… even as it has gone up. In fact, in the face of a rising market, sentiment has actually become less bullish. To be specific, in late February 2007, when the market was going strong (before the correction), bullish sentiment as measured by Hulbert, was 62.4%. Since then, the market has recovered the correction and then some. But newsletter bullish sentiment is now 40.6%

And Thursday’s rocket ride did not make one iota of difference! It seems like the newsletter writers out there are scoffing at the price action as merely a mirage. Who knows, it may very well be. But with history as a guide, we know that the probability of it being real is high when there isn’t much excitement accompanying market gains.

But (there’s always a but) the Investor’s Intelligence report on newletter sentiment shows a completely different picture. According to II there are 21.3% bears and 49.5% bulls. That is a fairly toxic ratio of bulls to bears. But if we look back to 2003 we see that after the bear market low was made, and as the market rallied almost continuously for the whole year, the sentiment was equally bearish according to II. So maybe history will repeat. But why are the sentiment measures so at odds?

I believe it is because Michael Burke and his team over at II use a different method to categorize newsletters. Rather than going by what the newsletters are recommending (which Hulbert does), they go by their feel of the bullishness or bearishness (or neutralness) of the newsletter after a reading. This is a much more subjective method and may account for the variance between the two sentiment measures. Ideally, we would like to see them agree with each other. But we can’t have everything now, can we?